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VALUATION OF GOODWILL
Meaning of Goodwill:-- Goodwill is the present value of a firm's anticipated super normal earnings. In other words, it is the value
of reputation of business house in respect of profits expected in future over and above the normal level of profits earned by
the undertakings belonging to the same class of business.

Factors affecting value of goodwill:-- Firm may have some advantage which may reduce competition or increase sales or
enable firm to produce goods at lower cost or of a better quality. The ultimate effect of this advantage will be higher sales and
higher profits. Various factors which give these advantages to the firm are:

(i) Favourable Location: If business is located at a place where raw materials easily available or it is located at a market place
where customers are attracted, business will be at the advantage. Such firm will save cost in transportation and will have
higher sales. Thus, favourable location will contribute to the goodwill of the firm,
(ii) Patent/Trade Mark Advantage: If firm possesses a patent or trade mark which has established its reputation in the market,
it will have higher sales,
(ii) Technical Know-how Advantage: If firm possesses technical know-how which is not available to competitors, firm will be able
to produce better quality goods and/or at lower cost,
(iii) Research and Development Advantage: If firm has its own research and development wing, it will be in a position to produce
goods of better quality and in accordance with current market demand.
(iv) Early Entry Advantage: If firm had entered in the business at early stage and presently entry in the business has become restrictive
due to government regulations or prohibitive cost, firm will be at the advantageous position in comparison to its competitors,
(v) Human Resource Advantage: If firm has a personnel policy which cares for human resource development, efficiency in all fields will
improve. There are following methods for valuing goodwill:
1. Simple/Average profit method;
2. Super profit method;
3. Annuity method;
4. Capitalization method.
1. Simple Profit Method:-- In this method, goodwill is valued on the basis of a certain number of years' purchase of the average
profits of the past few years.
Question 1. Profits earned during last three years by X Ltd are as follows:

2004 --- 5,00,000

2005 --- 6,00,000

2006 --- 4,00,000

Calculate goodwill on the basis of three year’s purchase price by

(a) average profit method

(b) weighted average profit method(if weights are not given)
(c) weighted average profit method if weights given are 1,3,6 respectively.

 SUNO MERI BAAT DHYAN SE

While calculating average profits (Average future maintainable profit) for the purpose of valuation of goodwill certain
adjustments are made, which are as follows:

(a) All non-recurring and abnormal expenses and losses not likely to occur in the future are added back to profits.
(b) Non-recurring or casual income not likely to recur in future are deducted from such profits.
(c) Expenses and losses expected to occur in future are deducted from such profits, (e.g. increase in rent, managerial remuneration
etc.)
(d) All profits likely to accrue in the future are added.
After above adjustments, average of the past years profits is calculated. Then such average profit is multiplied by certain
number of years, say 4 years. The resultant amount will be value of goodwill.

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Question 2 (Calculation of Future Maintainable Profits) TATA Ltd. desirous of selling its business to COC Ltd. has earned the
following profits (after tax) in the past three years: Rs. 4,00,000, Rs. 5,50,000 and Rs. 6,40,000. Following facts need to be
taken into consideration:

(i) Directors' fees Rs. 50,000 per year will not be payable by COC Ltd. whose existing board can easily manage the additional work.

(ii) Rent of Rs. 10,000 per month paid by TATA Ltd. will not be a charge against the profits of COC Ltd. as the latter company
has its own premises.

(iii) TATA Ltd. has not transferred its trade investments to COC Ltd. Hence, interest of Rs. 9,000 would not be earned by the
purchasing company.

(iv) TATA Ltd. had outsourced some of its business work for an annual contract of Rs. 1,24,000. However COC Ltd. has
enough surplus staff to manage the same. Hence savings of this cost. Calculate the Future Maintainable Profits.

Question 3. COC Ltd. agreed to purchase business of WIPRO Ltd. For that purpose, goodwill is to be valued at three years'
purchase of the average of previous 4 year's adjusted profits. The profits for the years ending 31.12.2016 to 31.12.2019 were
as follows: Rs. 40,400; Rs. 49,600; Rs. 50,000; Rs. 60,000. Following additional information is available as under:

a) On 01.09.2018, a major repair expenditure to plant and machinery for Rs. 12,000 was charged to revenue. This was agreed
to be capitalized for goodwill subject to 10% p.a. depreciation on diminishing balance method.
b) The closing stock for the year ending 31.12.2017 was over-valued by Rs. 4,800.
c) In order to cover cost of management, an annual charge of Rs. 9,600 should be made for valuation of goodwill.
Compute value of Goodwill.

Question 4. The following information is available about Big B Ltd.: Profits for the last four years are:

2005 - Rs. 1,75,000; 2006-Rs. 2,25,000; 2007-Rs. 3,15,000; 2008-Rs. 4,50,000. On going through the accounts of
the company it was found that:

(a) Profits are before managerial remuneration of Rs. 50,000 in 2005;

Rs. 70,000 in Rs. 2006; Rs. 80,000 in 2007 and Rs. 1,00,000 in 2008.

(b) In 2005 there was a loss of Rs. 45,000 because of sudden floods in the nearby river.
(c) The closing stock of 2006 was overvalued by Rs. 35,000. However in 2007 the opening stock was correctly valued.
(d) In 2007, there was a repair of 25,000 resulting in the improvement of plant. However the amount spent was charged to
revenue. Now it is agreed to be capitalized for valuation of goodwill subject to a depreciation charge of 10% p.a. on diminishing
balance method. Calculate the value of goodwill on the basis of 4 years' purchase of Future Maintainable profits of the
business calculated on weighted average profit of the last four years. The appropriate weights to be used for respective
years are: 2005-1; 2006-2; 2007-3; and 2008-4.
Solution:

(i) Adjusted Profit

2005 2006 2007 2008
Rs. Rs. Rs. Rs.
Profit (As Given) 1,75,000 2,25,000 3,15,000 4,50,000
Less : Managerial Remuneration (50,000) (70,000) (80,000) (1,00,000)
1,25,000 1,55,000 2,35,000 3,50,000
Add : Loss from floods 45,000 — — —
1,70,000 1,55,000 2,35,000 3,50,000
Less : Overvaluation of closing stock — (35,000) — —
1,70,000 1,20,000 2,35,000 3,50,000
Add : Repairs charged to
revenue account now
to be capitalized — — 25,000 —
1,70,000 1,20,000 2,60,000 3,50,000

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Less : Depreciation on Rs. 25,000 — — (2,500) —
at 10% 1,70,000 1,20,000 2,57,500 3,50,000
Less: Depreciation at 10% on Rs. 22,500 — — — (2,250)
1,70,000 1,20,000 2,57,500 3,47,750

(ii) Weighted Average Profit = Adjusted Profit x Weight = Weighted Amount

2005 1,70,000 x 1 = 1,70,000

2006 1,20,000 x 2 = 2,40,000
2007 2,57,500 x 3 = 7,72,500
2008 3,47,750 x 4 = 13,91,000
25,73,500

Weighted Average Profit or Future Maintainable Profit = 25,73,500 ÷10 = 2,57,350

Goodwill = 2,57,350 x 4 = Rs. 10,29,400

Question:5. A Ltd. proposed to purchase the business carried on by M/s X and Co. Goodwill for this purpose is agreed to be valued
at three years' purchase of the weighted average profits of the past four years. The appropriate weights to be used are:

Year Weight Profits (Rs.)

2005-06 1 1.01,000
2006-07 2 1,24.000
2007-08 3 1,00,000
2008-09 4 1,40,000
On a scrutiny of the accounts, the following matters are revealed:

(a) On 1 December 2007 a major repair was made in respect of the plant incurring Rs. 30,000 which was charged to
revenue. The said sum is agreed to be capitalized for goodwill, calculation subject to adjustment of depreciation of 10%
p.a. on reducing balance method.
(b) The closing stock for the year 2006-07 was overvalued by Rs. 12,000.
(c) To cover management cost, an annual charge of Rs. 24,000 should be made for the purpose of valuation of goodwill.
Compute the value of goodwill of the firm. C.S. (Inter) Dec. 1999 Modified), CS INTER 2001(Modified)

Super Profit Method:- Under this method annual super profit is calculated. This represents excess of future maintainable
profits over normal profit. Goodwill is calculated by multiplying average super profit by certain number of year’s purchase price.

Question 6. Average profit = 2,50,000

Capital employed = 20,00,000

Normal rate of return = 10%

Calculate goodwill on the basis of three year’s purchase of super profit .

(A) Normal Profit:-- This requires following information:

(a) Capital Employed in the business.

(b) Normal rate of return expected from the business.
NORMAL RATE OF RETURN-- The normal rate of return is that rate of earning which investors in general expect on their
investments in the particular type of industry. Normal rate of earning depends upon the bank rate, market need, period of
investment and risk attached to the investment. Normal rate of return = Risk free return + Risk premium

Risk free return =

Risk premium =

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Normal Profit = Capital Employed or / Average Capital Employed x Normal Rate

(B) Capital Employed:-- This represents net assets employed in the business.

 (AAO KASAM KHATE HAI)

While calculating capital employed following points will be taken into account:

1. All assets except Goodwill, Non-trade investments and miscellaneous expenses should be taken.
2. Assets will be taken at current market prices.
3. All Liabilities (payable to outsiders) should be deducted.
4. Proposed dividend should not be deducted as it is part of current year's profit.
5. Funds/Reserves in the nature of liability should be deducted e.g. provident fund, Workers profit sharing fund, Gratuity fund.
Now a days, the concept of average capital employed has become significant.

 Average capital employed will be simple average of opening and closing capital.
 Alternatively, half of current year's profit will be deducted from closing capital.
 Alternatively, half of current year profit will be added to the opening capital.
 However, there is a school of thought which advocates calculation of normal profit on the basis of closing capital.

Question 7: average capital employed = 10,00,000

Risk free return = 10%
Risk premium = 5%
Average profit = 2,20,000
Calculate goodwill on the basis of 3 year‘s purchase of super profit

Question 8. Capital employed = 8,00,000

Current year profit before tax = 80,000
Tax rate = 40%
Average profit of last 4 years = 1,10,000
Calculate goodwill on the basis of 3 year‘s super profit.

NOTE -- For the purpose of valuation of goodwill, profit means profit …………………………………………….

Question 9. (Calculation of Normal Rate of Return) A limited company declares a dividend of 20% on its shares of Rs. 100. Rs. 75
paid up. The shares are quoted in the market at Rs. 120. Calculate the normal rate of return.

Question 10. (Number of Years' Purchases of Super Profit) The balance sheet of X Ltd. as at 31.03.2008 is as follows:

Liabilities Rs. Assets Rs.

8% 5,000 Preference Shares Goodwill 10,000
of Rs. 10 each 50,000 Fixed Assets 1,80,000
10,000 Equity Shares of Investments 20,000
Rs. 10 each 1,00,000 (5% Government Loan)
Reserves (including provision Current Assets 1.00,000
for taxation Rs. 10,000) 1,00,000 Preliminary Expenses 10,000
8% Debentures 50,000 Discount on Debentures 5,000
Creditors 25,000
3,25,000 3,25,00
The average profit of the company (after deducting interest on debentures and taxes) is Rs. 31,000. The market value of
the machinery included in the assets is Rs. 5,000 more. Expected rate of return is 10%. Calculate the value of goodwill at
three times of the super profits.

Question 11. The balance sheet of Manufacturing Co. Ltd. disclosed the following financial position as on 31 March 2016:

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 ACCOUNTS CA/CMA Santosh Kumar
Balance Sheet As On 31 March. 2006

Liabilities Rs. Assets Rs.

Paid up Capital : Goodwill at cost 30,000
30,000 Shares of Land and Buildings at cost 1,75,00
Rs. 10 each fully paid 3,00,000 (less Depreciation)
Capital Reserve 20,000 Plant and Machinery at cost 90,000
Sundry Creditors 71,000 (less Depreciation)
Provision for Taxation 55,000 Stock at cost 1,15,000
Profit and Loss Account 66,000 Book Debts 98,000
Less : Provision 3,000 95,000
■ 7,000
Cash at Bank
5,12,000 5,12,00

You are asked to value the goodwill of the Manufacturing Company Ltd. on the basis of five years' purchase of super profit,
for which purpose the following information is supplied:

(i) Adequate provision has been made in the accounts for income tax and depreciation.

(ii) The rate of income tax may be taken at 50%.

(iii) The average rate of dividend declared by the company for the past five years was 15%.

(IV) The reasonable return on capital invested in the class of the business done by the company is 12%.

Question: 12 (Purchase of Super Profit Method) The following is the balance sheet of Shaifali Ltd. as on 31 December 2007:

Rs. Rs.
Equity Share Capital 9,00,000 Goodwill 1,50,000
10% Preference Share Machinery 5,00,000
Capital 4,00,000 Buildings 7,50,000
General Reserve 4,00,000 Investments 2,00,000
Profit and Loss Account 3,00,000 Current Assets 12,00,00
Bank Loan 2,00,000
Sundry Creditors 6,00,000
28,00,00 28,00,00
Additional information is as under

(i) Fixed assets are worth 20% above their book value. Depreciation on appreciation in value of fixed assets not to be considered
for valuation of goodwill.

(ii) Of the investments, 60% are non-trading and the balance is trading. All trade investments are to be valued at 25% above cost. A
uniform rate of dividend at 15% is earned on all investments after tax.

(iii) Goodwill is to be valued on the basis of 4 years' purchase of the super profits based on average profit (after tax) of the last 3 years.

Profits (after tax at 50%) are as follows:

2005 - Rs. 4,00,000; 2006 - Rs. 4,30,000; 2007 - Rs. 4,50,000

(iv) In 2005, new machinery costing Rs. 20,000 was purchased but wrongly charged to revenue. No effect has yet been given for
rectifying the same. Depreciation charged on machinery is at 10% p.a. on reducing balance method. Compute the Value of
Goodwill

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 ACCOUNTS CA/CMA Santosh Kumar
Question: 13. From the following information, calculate goodwill on the basis of 4 years' purchase of super profits:

Balance Sheet of XYZ Ltd. As On 31 March 2018

Liabilities Rs. Assets Rs.

Share capital (Rs. 10 share) 10,00,000 Goodwill 1,00,000
Reserves and surplus 4,00,000 Land and building 3,00,000
Creditors 3,00,000 Plant and machinery 8,00,000
Investments 1,00,000
Stock 2,00,000
Debtors 1,50,000
Cash at bank 50,000
17,00,000 17,00,000
Profits before tax for 2017-18 amounted to Rs. 6,00,000 including Rs. 10,000 as interest on investments. However an
additional amount of Rs. 50,000 would be required to be spent for smooth running of the business. Market values of land
and building and plant and machinery are estimated at Rs. 9,00,000 and Rs. 10,00,000 respectively. Further, depreciation to
the extent of Rs. 40,000 shall be taken into consideration. Income tax rate may be taken at 50%. It may be noted that
additional depreciation is not allowed for income tax purposes. Rate of return at 20% before tax may be considered
normal. For the purpose of determining the actual rate of return, profit for this year, after aforesaid adjustments, may be
taken as expected average profit. Similarly average trading capital employed is also to be considered on the basis of the
position in this year.

Question 14. Ramesh runs a general store. His net assets on 31st December, 1995 amounted to Rs. 22,00,000. After paying
a rent of Rs. 20,000 a year and a salary of Rs. 10,000 annual to the manager, he earns a profit of Rs. 1,50,000. His landlord
is interested in acquiring the business. 8% is considered to be a reasonable return on capital employed. Find out the value
of goodwill based on 3 years' purchase of super profit.

Solution:

Net assets as on 31.12.95 22, 00,000

Add: capitalized value of rent on the basis of

 20,000 100 
Capitalization rate of 10%   2, 00,000
 10 
Capital employed for landlord 24, 00,000

 24,00,000  8 
Normal profit =   =Rs., 1,92,000
 100 

Average annual profit = Rs. 1, 50,000

Add: Rent = Rs. 20,000

= Rs. 1, 70,000

Question:15 .DO NOT SOLVE THIS QUESTION, EVEN THOUGH SOLVED IN VIDEO CLASS. NOT RELEVANT FOR MCQ.

Capitalization method:-

Question 16 Capital employed(net assets) at end = 6,00,000, Average profit = 1,00,000

Normal expected return= 10%, Calculate goodwill by capitalization method

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 ACCOUNTS CA/CMA Santosh Kumar
Question:17. The following particulars are available in respect of the business carried on by a trader:

1. Profits earned for the years :

2007-08 = Rs. 50,000

2008-09 = Rs. 60,000

2009-10 = Rs. 55,000

2. Normal rate of return = 10%

3. Capital employed = Rs. 3,00,000
4. Present value of an annuity of one rupee for 5 years at 10% = Rs. 3.78.
5. The profit included non-recurring profits on an average basis of Rs. 3,000.
You are required to calculate the value of goodwill:

(i) As per five years purchase of Super-profits;

(ii) As per capitalization of Super Profits Method; and

(iii) As per Annuity Method.

Question:18 . The net profits of a company after providing for taxation, for the past 5 years are: Rs. 40,000, Rs. 42,000, Rs.
45,000, Rs. 46,000, Rs. 47,000. The capital employed in the business is Rs. 4,00,000 on which a reasonable rate of return of
10% is expected. It is expected that the company will be able to maintain its super profit for the next five years.

(i) Calculate the value of the goodwill of business on the basis of annuity of super profits, taking the present value of an annuity
of one rupee for five years at 10% interest is Rs. 3.78.

(ii) How would your answer differ if the goodwill is calculated by capitalizing the excess of the annual average distributable profits
over the reasonable return on capital employed on the basis of same return of 10%?

Solution: Rs.

Total Profits for 5 years ( 40,000 + 42,000 + 45,000 + 46,000 + 47,000) 2,20,000
Average Profit = 2,20,000/5 44,000

Normal Profit = 10% of Rs. 4,00,000 (capital employed) 40,000

Super Profit = Excess of average actual profits over normal profits = Rs. 44,000 - Rs. 40,000 = Rs. 4,000

(i) Goodwill at 5 years' purchase of super profits discounted at 10% p.a.:

= Rs. 4,000 X 3.78 = Rs. 15,120

(ii) Goodwill on the basis of capitalization of super profits :

4,000 x 100
—- = Rs. 40,000
10
Question:19 DO NOT SOLVE THIS QUESTION, EVEN THOUGH SOLVED IN VIDEO CLASSES. NOT RELEVANT FOR MCQ.

Question:20 DO NOT SOLVE THIS QUESTION, EVEN THOUGH SOLVED IN VIDEO CLASSES. NOT RELEVANT FOR MCQ

Question:21 The following information relates to the business of a partnership firm:

(a) Average capital employed in the business : Rs. 7,20,000.

(b) Net trading profits of the firm for the past three years after taxation, were: Rs. 1,07,600; Rs. 90,700 and Rs. 1,12,500.

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 ACCOUNTS CA/CMA Santosh Kumar
(c) Reasonable return expected in the same type of business is 10%.

(d) Fair remuneration to the partners for their services is Rs. 12,000 per annum. Calculate the value of goodwill:

(1) On the basis of five years’ purchase of the annual average super profit.

(2) On the basis of capitalization the annual average super profit at the reasonable return of 10%; and

(3) On the basis of an annuity of super profits, taking the present value of annuity of one rupee for five years at 10 per
cent interest is 3.78.

Solution:

Total Profit = Rs. 1,07,600 + 90,700 + 1,12,500 3,10,800

Average Profit = 3,10,800/3 1,03,600

Less: Remuneration of Partners 12,000

Actual Average profits 91,600

Less: Normal profit (7,20,000 X 10/1000) 72,000

Super Profit (91,600-72,000) 19,600

(i) Goodwill on the basis of 5 years purchase (19,600 X 5) = Rs. 98,000

(ii) Goodwill on the basis o capitalization (19,600 X 100/10) = Rs. 1,96,000
(iii) Goodwill on the basis of annuity of super profit (19,600 X 3.78)= Rs. 74,088
Note: Tax has been ignored

Question 22. DO NOT SOLVE THIS QUESTION, EVEN THOUGH SOLVED IN VIDEO CLASSES. NOT RELEVANT FOR MCQ

Question 23.: DO NOT SOLVE THIS QUESTION, EVEN THOUGH SOLVED IN VIDEO CLASSES. NOT RELEVANT FOR MCQ

MOST IMPORTANT NOTE – WATCH MY LECTURE ON ACCOUNTING STANDARD 26 TO COMPLETE THIS CHAPTER.

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